Monetary policy effect in an economy with heavily managed exchange rate

Trang 1 Monetary Policy Effect in an Economy with Heavily Managed Exchange Rate BUI THANH TRUNG University of Economics HCMC - trungbt@ueh.edu.vn AbstractThis paper investigates the effe

Monetary Policy Effect in an Economy

with Heavily Managed Exchange Rate

BUI THANH TRUNG University of Economics HCMC - trungbt@ueh.edu.vn

Abstract

This paper investigates the effect of monetary policy on macroeconomic variables in Vietnam, a small open economy with heavily managed exchange rate The monetary policy shock is identified by the sign restriction methodology Unlike previous studies, a monetary policy contraction is associated with an increase in interest rate, a decrease in central bank credit, a drop in the stock of foreign exchange reserves, and a fall in broad money The empirical results show several interesting findings First and foremost, output and price, which are represented by industrial production index and consumer price index, show a reduction following a positive shock to monetary policy, which is consistent with the prediction of standard economic theories Moreover, trade balance exhibits a temporary increase before declining in the mid-term A noteworthy finding is that exchange rates show overshooting response, appreciating on impact and peaking after eight to nine months, following a contraction in monetary policy, which is in line with the overshooting hypothesis Furthermore, foreign exchange policy has insignificant impacts on exchange rate movement while exercising positive and significant influences on price and money Finally, our identification resolves certain puzzles in the literature such as price puzzle and exchange rate puzzle The findings suggest two important implications: (1) monetary policy should account for the evolution of foreign exchange intervention policy to effectively control output and price; and (2) developing financial markets is a necessity to alleviate inflationary pressure caused by foreign exchange policy

Keywords: sign restriction; monetary policy; exchange rate; fixed exchange rate

1 Introduction

An enormous number of empirical studies emphasize the importance of exchange rate channel in the conduct of monetary policy in the context of developed countries with flexible exchange rate regime In those studies, monetary policy is widely defined as unexpected changes or shocks to either interest rate or money However, for a small and open country, it is suggested that monetary policy should be defined in different ways such as spread between interbank interest rate and the exchange rate depreciation ratio for Turkey (Berument, 2007) or the combination of positive shocks to interbank interest rate and negative shocks to the stock of foreign reserves for Taiwan The phenomenon also emerges in Vietnam, of which the economy is much smaller than that of Turkey and the exchange rates are heavily managed just like Taiwan Compared to Taiwan, the money market is underdeveloped in Vietnam and monetary policymakers have less control over the short-term interest rate Instead, they manipulate policy rates in order to increase or decrease the market interest rates as well as provide credit to certain banks directly through the purchase of short-term securities and even long-term securities in emergent situations Furthermore, exporting is an important stimulus for domestic economic activities and central bankers frequently intervene the foreign exchange market to keep the exchange rates fixed, which is essential for maintaining the stability of revenues and costs incurred in exporting enterprises Regard to this, the setting of monetary policy includes the manipulation in four variables such as policy rate, central bank credit, the stock of foreign reserve, and broad money

With respect to empirical estimation, the literature suggests several approaches to examine the effect of monetary policy First and foremost, the recursive VARs were used in a considerable number

of studies See, for instance, Sims (1992) and Berument (2007) However, this method provides plausible results when analyzing a relatively close and large economy such as United State (Ho & Yeh, 2010; Kim & Roubini, 2000) In case of small and open economy, the analysis should employ the non-zero contemporaneity methodology because it allows instantaneous reactions of monetary policy instrument to macroeconomic shocks (Kim & Roubini, 2000) Ho and Yeh (2010), on the other hand, adopted sign restriction methodology to investigate the monetary policy transmission in a fixed-exchange rate economy like Taiwan

In this paper, we also employ the sign restriction for the identification of monetary policy in Vietnam, which is also a small open economy with heavily managed exchange rate Unlike Ho and Yeh (2010) scheme, this paper associates a monetary policy contraction with a rise in policy rate and

a fall in broad money, central bank credit as well as foreign exchange reserves In the language of sign restriction, a monetary policy contraction does not cause a decrease in policy rate and does not lead to an increase in broad money, central bank credit, and foreign exchange reserves Other business variables such as output, price, trade balance, and exchange rate are unrestricted because the main focus of this paper is to analyze whether and how these variables react to unexpected changes in monetary policy instruments Furthermore, unlike other central bankers, monetary

authorities in Vietnam emphasize the objective of fostering economic growth as directed by the government and have neither explicit nor implicit target for price stability Therefore, it is important

to answer the question as to whether monetary policy contraction is effective in controlling output and inflation in case of Vietnam

2 Literature review

2.1 Exchange rate channel and macroeconomic variables

Since the world is more integrated and the number of countries adopting flexible exchange rate regime is increasing, Mishkin (2013) argues that economists should place a greater emphasis on exchange rate channel in monetary policy transmission This channel works mainly through the interest effect, implying that a rise in real domestic interest rate increases the relative attraction of assets denominated in domestic currency to those denominated in foreign currency, which then causes an appreciation of domestic currency As a result, domestic goods become more expensive than foreign goods, which reduces net export (export minus import) and thus economic activities are contracted

Another theoretical framework, which is increasingly cited in the literature, is the overshooting hypothesis proposed by Dornbusch (1976) Based on the hypothesis of sticky price, following an increase in domestic interest rate the nominal exchange rate will appreciate instantaneously and then depreciate consistent with the theory of uncovered interest parity The mechanism could be explained as follows As central bankers tighten monetary policy by either increasing interest rates

or reducing money supply, the conditions of general economy become more difficult with a rise in funding costs, transaction costs, and information costs However, enterprises cannot immediately modify the quoted prices for goods and services and price level shows a sluggish change On the contrary, currency markets are more liquid, and prices change easily and frequently Hence, a monetary policy contraction immediately causes a rise in real interest rate, increasing the relative attraction of domestic assets and resulting in an impact appreciation of domestic currency Once domestic currency is overvalued, market expectations change, and a depreciation is likely to occur

In summary, a monetary policy contraction leads to an impact appreciation and then a gradual depreciation for a prolonged period

However, some puzzles have been revealed when empirically analyzing the impulse response function of macroeconomic variables to monetary policy shocks The first puzzle refers to a situation where exchange rates shows a response of depreciation (rather than appreciation) after a contraction shock to monetary policy, which has been termed as exchange rate puzzle (Grilli & Roubini, 1995, 1996; Sims, 1992) The second puzzle appears when exchange rates appreciate persistently for a prolonged period up to 3 year following a monetary policy contraction (Clarida & Gali, 1994; Grilli & Roubini, 1995, 1996; Kim, 2001, 2005) Therefore, exchange rates have a hump-shaped curve on

impact of monetary contraction, which violates the theory of uncovered interest parity The economists have widely termed the phenomenon as delayed overshooting puzzle

2.2 Solving the puzzling response of exchange rate on the impact of monetary policy shocks

There are three choices of VAR models to analyze monetary policy transmission, including recursive, structural (zero restriction), and sign restricted The first one, recursive VAR, was employed in many studies but its estimations are contrasting with conventional theory Applying recursive ordering for five large industrial countries, Sims (1992) found that exchange rate puzzle could be eradicated by properly choosing the indicator of monetary policy shock in the presence of demand shocks such as short-term interest rate Although the empirical results seem reasonable, several puzzles emerged following a monetary contraction: persistent appreciation of domestic currency for France and Japan or persistent depreciation of home currency for Germany Similar to Sims (1992), Grilli and Roubini (1995) also employed recursive VAR model to analyze the dynamic interaction between exchange rate and monetary policy for non U.S G7 countries and documented puzzling response of exchange rate, showing a persistent (rather than impact) appreciation before exhibiting a gradual depreciation following positive shock to the differential between domestic and foreign interest rates for most countries in G7 group Following studies showed intensive evidences

of exchange rate puzzle or delayed overshooting (Eichenbaum & Evans, 1993)

As suggested by Sims (1992), many studies add more shocks into VAR model to capture the great pool of information monitored by the central bankers in monetary policy setting For instance, commodity price or oil price are used to account for the fact that policymakers reflect the inflationary pressures in deciding the monetary policy stance A few studies make a further effort by adding factors which represent general concepts like “economic activities” The approach extends the scale

of VAR model to capture the enormous pool of information monitored by central bankers when formulating monetary policy stance Although the large-scale VAR shows advantages in solving puzzles in the analysis of monetary policy transmission, it seems to be feasible for the analysis of developed countries where fundamental statistics are adequate and well managed In case of developing country, the restriction of data availability forces studies on this field to rely on small-scale VAR

Another explanation for the inefficiency of recursive VAR in solving puzzling outcomes of monetary policy shock is that the simultaneous interaction between exchange rate and interest rate

is more likely to happen in small and open countries In fact, G7 economies are opener and smaller than that of the United States In such cases, the non-recursive contemporaneous restriction demonstrates the merit of eliminating puzzles in the monetary policy transmission Cushman and Zha (1997) employed this approach when studying Canada, which is considered as relative small economy to the United States They found no puzzling interaction between money supply, interest rate, and exchange rate based on the assumption that the central bank quickly responds to concurrent shocks in financial variables like exchange rates Kim and Roubini (2000) further

developed the identification strategy of Cushman and Zha (1997) to account for the openness of a small economy Kim and Roubini (2000) argued that short-term interest rates quickly respond to innovations in macroeconomic variables such as money stock, world oil price, and exchange rate while exchange rates are affected by shocks to other variables Therefore, they did not impose zero restrictions on the interaction between contemporaneously interacted variables in structural VAR model

Sign restriction is another approach used to solve exchange rate anomalies in a small and open country Uhlig (2005) adopted the sign restriction methodology and identified a monetary policy contraction as an increase in federal funds rate associated with a reduction in non-borrowed reserves and a decline in price level The sign restriction is imposed on inflation level due to the objective of price stability pursed by Federal Reserves The study found a monetary policy contraction leads to a fall in output in the short run For Russia, Granville and Mallick (2010) emphasized the importance

of exchange rate intervention in an economy with managed floating regime and investigated whether frequent intervention in foreign exchange market influences the performance of economic activities and price stability They imposed sign restriction on selected variables to define exchange shock as well as inflation targeting shock and found that exchange rate targeting exercised relatively strong impact on inflation Rafiq and Mallick (2008) preferred to study the effect of monetary policy on output in three strong economies in European area like German, Italy, and France The study used four shocks to define the stance of monetary policy, including narrow money, exchange rate, interest rate, and inflation The former two characterizes the openness degree of these economies while the latter two capture the objective of price stability in formulating monetary policy by European monetary policymakers In fact, a contraction in monetary policy is associated with an increase in interest rate, a decline in money, an appreciation of domestic currency, and a decrease in price They found that monetary policy shocks are not a dominant driver of output in three EMU countries, suggesting that accounting for national information about inflation and output gap is essential to improve the quality of monetary policy conduct in selected EMU economies

The sign methodology of Uhlig (2005) shows appealing features in identifying monetary policy innovation as well as eradicating puzzling response of macroeconomic variables to monetary policy shock not only for studies in countries where exchange rate are floating but also for small-open economies with managed exchange rate regime Ho and Yeh (2010) imposed sign restriction on both interest rate and foreign reserves (rather than exchange rate or exchange rate depreciation as in previous studies) to investigate monetary policy shock in Taiwan because they pointed that monetary authorities in this country usually intervenes the exchange market to stabilize the fluctuation of exchange rate As a result, monetary policy can operate through both interest rate and the stock of foreign reserve Consequently, they associate a monetary policy contraction with a rise in interest rate and a fall in the stock of foreign reserves The findings provide impulse response without any puzzles whereas other schemes like those of Cushman and Zha (1997) and Berument (2007) suffer puzzles

This study also employs the new method of VAR, sign restriction, for investigating the effect of monetary policy on macroeconomic variables in Vietnam Unlike most of previous studies, it focuses the case of Vietnam where exchange rates are heavily managed and central bankers regularly intervene the exchange rate market to stabilize the value of domestic currency against foreign currencies Therefore, two policies including monetary policy and exchange rate intervention policy are interacted with each other Unlike the identification of Uhlig (2005) and Ho and Yeh (2010), monetary policy shocks are identified through unexpected changes in policy rate, broad money, and state bank credit since these instruments are easily influenced by the State Bank of Vietnam The stock of foreign exchange reserves is also included in the identification scheme because it reflects the intended objective of remaining the stability of exchange rate pursued by the central bank in Vietnam

3 Methodology

There are several strategies to estimate model (1) in most of the literature One is to identify structural shocks using recursive scheme with a Cholesky decomposition and the other is using zero-restriction on either short- or long-run coefficients (Sims, 1980) However, most of the cases these restriction leads to results inconsistent with economic theory (Canova & Pina, 2000) such as exchange rate puzzle (Grilli & Roubini, 1995, 1996; Sims, 1992) and delayed overshooting puzzle (Clarida & Gali, 1994; Grilli & Roubini, 1995, 1996; Kim, 2001, 2005)

Instead, we can analyze the monetary policy effect on output, price, and other macroeconomic variables by assigning a prior assumption on the sign of selected shocks in VAR model based on the fundamental understanding of conventional economic theories (Uhlig, 2005) Unlike the strategy of Uhlig (2005) and those of previous studies, the identification strategy used in this paper accounts for the interaction of dubious policy, including monetary policy and exchange intervention policy in the context of a small open country of which the exchange rates are heavily managed

3.1 VAR with sign restriction

The VAR has following specification:

where Y t is an n x 1 vector of macroeconomic variables and policy variables, B i are n x n matrices

of coefficient, and u t is the error matrix with variance – covariance matrix  According to economic theory, matrix u t can be defined in term of some structural shocks (see equation (2))

t t

where A is a n x n matrix of structural parameters and v t are the structural shocks that has zero mean and a variance of unit Therefore, the variance and covariance can be written as:

' '

The matrix A requires a least n(n-1)/2 restrictions to be exactly identified Most of the literature imposes restrictions on model coefficients to recover structural shocks, either using a Cholesky decomposition or applying zero restriction on short- or long-run coefficients The sign restriction,

on the other hand, imposes a prior belief that selected variables do not increase or decrease for a certain period following a specific shock

In order to recover the vector of structural shocks, it is essential to obtain an impulse vector of size n, a, as follows:

'

a A

where is a n x 1 vector of unit length andAA  ' is a Cholesky decomposition of 

Next, the response vector derived from OLS estimation of unrestricted VAR with a Cholesky decomposition is multiplied by the vector a defined above The impulse response functions are checked to ensure the imposed signs are matched

Uhlig (2005) suggested two approaches to find the sign-matched impulse response functions The first one is the rejection method which bases on the acceptance and rejection of a sub-draw for vector

, which implies that all impulse response functions satisfying sign restriction are treated equally

In this paper, we prefer the second one, termed as the penalty functions, since it minimizes the criterion function of sign restriction violation This approach makes an attempt to obtain an impulse response function that matches the sign restrictions as much as possible

3.2 Identification of important policy shocks based on sign restriction methodology

Table 1 indicates the identification of monetary policy shock and foreign exchange intervention shock As observed, a monetary policy contraction does not cause a fall in policy rate and a rise in central bank credit, foreign exchange reserves, and broad money Shocks to foreign exchange intervention involve any unexpected changes in the stock of foreign exchange reserves

The identification of monetary policy shock is distinguished with that of Berument (2007) where central bankers can decrease the liquidity by either increasing interest rates at a given depreciation level or buying domestic currency while keeping interest rate unchanged This strategy is less valid

in an economy of which exchange rates are heavily managed (Ho & Yeh, 2010) In Vietnam, central bankers tend to keep exchange rate fixed at certain levels while adjusting monetary policy instruments like interest rate, broad money, or central bank credit Therefore, innovation in the stock

of foreign exchange reserve is an important signal for policymakers to make decisions about monetary policy instruments

In a similar fashion to Like Ho and Yeh (2010), we believe that a monetary policy contraction is also associated with a fall in foreign exchange reserves In the language of sign restriction, a monetary policy contraction does not cause to an increase in foreign exchange rate reserves This prior assumption is essential for capturing the actual contraction in monetary policy As a small and open economy, development policy depends on exporting of goods and services overseas Moreover, the underdevelopment of financial markets as well as financial intermediation cause difficulties for a country to channeling capital inflows to productive local uses, resulting in an excessive supply of foreign exchange If central bankers take no actions, the nominal exchange rates would appreciate and lead to a reduction in export and the general economic activities For this reason, central bankers frequently accumulate the stock of foreign reserves, implying that aggregate money has a tendency

to increase and the economy may face high inflation in the long run

However, our identification is different with that of Ho and Yeh (2010) since policy rates rather than short-term interest rates are used to access the stance of monetary policy One reason is that policy rates are completely controlled by the State Bank of Vietnam Compared with Taiwan, Vietnam has underdeveloped financial markets that prevent central bankers from quickly influencing the setting of interest rates in the market

Moreover, different with most of previous studies, shocks to credit that banks receive from the State Bank of Vietnam is also included to define the contraction shock to monetary policy in Vietnam Since monetary authorities have weak control over the movement of short-term interest rates, they can increase liquidity for the economy by directly providing loans to certain banks during emergent situations This type of credit then can be allocated to specific economic sectors directed by the government such as farming Therefore, the inclusion of central bank loans is better reflect the stance

of monetary policy in Vietnam

Table 1

Identification of monetary policy shock and exchange rate policy shock

Industrial production index

Consumer price index

Trade balance

Exchange rate

Policy rate

Central bank credit

Foreign exchange reserves

Money

Monetary

Exchange rate

intervention

shock

There are several reasons for leaving the impulse response of output and price (represented by industrial production index and consumer price index respectively) determined by the data First and foremost, we want to examine the effect of monetary policy on its ultimate goal of increasing output

in the economy Furthermore, Vietnamese central bank has neither explicit or implicit commitment

to the objective of price stability, which is total different with central banks in developed countries

such as the United States and European Union members Therefore, there is no sign restriction imposed on the proxies for output and price in the analysis We also leave the impulse response of trade balance and exchange rate unrestricted since it is necessary to examine whether the identification used in this paper can resolve puzzles in the interaction between exchange rate and monetary policy in the literature

Since Vietnam adopts a fixed exchange rate regime, the stock of foreign exchange is frequently changed to stabilize the supply of and demand for foreign exchange and keep exchange rates stable Therefore, innovations to monetary policy instruments are not important information for the setting

of foreign exchange intervention policy As shown in Table 1, there is no sign restriction put on policy rate, state bank credit, and money In addition to this, the responses of output, price, trade balance, and exchange rate are left unrestricted This identification scheme provides evidence about the effect

of foreign exchange intervention on output and price as well as the response of monetary instruments like policy rate, state bank credit, and money

3.3 Data

The VAR model in this paper consists of eight endogenous variables of which four variables including policy rate, foreign exchange reserves, state bank credit, and broad money are used to access the monetary policy setting Exchange rates are included because it is an important shock in the transmission mechanism of monetary policy in a small open country where economic growth is significantly contributed by exporting goods and services to foreign countries Industrial production index and consumer price index are business cycle variables that are intensively used to represent output and price in the literature All variables with the exception of policy rate are presented in the natural logarithm form

The series of industrial production index is derived from two sources The first part of the series which spans over the period January 2001 - June 2013 is retrieved from the website Asia Regional Integration Center The remaining of the series until July 2016 is derived from General Statistics Office of Viet Nam Both are modified so that they are calculated on the same base year of 2010 Other series of the dataset are collected from the International Monetary Funds (IMF) and also span from January 2001 to July 2016

4 Empirical results

4.1 Empirical evidence from impulse response analysis

Figure 1 plots the response of macroeconomic variables following a monetary policy contraction, which is estimated by the penalty method of Uhlig (2005) As observed, there are three lines for each impulse response plot The median response is the middle line while the upper and lower line are

16th and 84th percentile from a sample of 10000 draws retrieved from posterior distribution respectively The figure shows that when central bankers tighten monetary policy, policy rates show

an impact increase, lasting for about 8 months before reducing while foreign exchange reserves

exhibit persistent decreases for a prolonged period of about 30 months On the other hand, credit that banks borrow from the State Bank of Vietnam reduces significantly on impact but the negativity fades out quickly after 3 months The negative response of state bank credit is persistent in the long run Money exhibits a permanent decrease following a contraction in monetary policy It is noteworthy that the response of these four variables is restricted by construction for identifying monetary policy shocks

The emphasis here is on the impulse response function of unrestricted variables such as output, price, exchange rate, and trade balance Following a positive shock to monetary policy, price shows

a persistent decrease, reaching the lowest level after about one and a half year Thereafter, the response shows a persistent increase until 60th month The initial increase in price provides evidence

of price stickiness in Vietnam It implies that firms does not adjust price at higher frequency when the macroeconomic environment changes One attribute is that competition in the market is relatively low; firms are not under pressure to reduce prices to compete with other firms The finding about the impulse response function of price to great extent is contrast with those of previous studies where monetary policy represented by either money supply or short-term interest rate exercises insignificant or temporary effects on the development of inflation in Vietnam (Bhattacharya, 2014; Hung & Pfau, 2009) In fact, the negativity of price reaction to a monetary policy contraction is consistent with the prediction of standard economic theories as well as the empirical findings of Phan (2014)

On the contrary, output, which is represented by industrial production index, shows a noisy pattern of movement in the first few months after a monetary policy contraction In fact, output shows an impact decrease, rising in the next few months, and then showing a permanent and significant decrease The negative effects of a positive shock to monetary policy on both output and price level are protracted for a lengthy period up to 60 months The negativity in the response of output to a monetary contraction is plausible and well-supported by previous studies on monetary policy transmission in Vietnam, such as Bhattacharya (2014), Hung and Pfau (2009), and Thu Thuy Vinh (2015)

A noteworthy finding is that in a few months following a contraction in monetary policy, price and output exhibit positive response, which suggests unexpected changes in the expectation of agents The phenomenon provides evidence of the adverse effects of monetary policy in emerging country, which was mentioned in the study of Maćkowiak (2007) In an economy where the problems

of information asymmetry is severe and private sector has an assumption that central bankers may have unavailable information about output and price, the stance of monetary policy operates as an informative signal about the performance of the economy in the future Therefore, in the short run following a contraction monetary policy, the partially irrational agents may quickly update their expectation and behaviors, which counteracts the effects of intended policy In the long run, private sector is certain about the stance of monetary policy, they reverse their behaviors and the restrictive monetary policy shows its intended effects, leading a decline in both output and price